When Genius Failed by Roger Lowenstein

“‘You’re picking up nickels in front of bulldozers,’ a friendly money manager warned.”

Financial journalist Roger Lowenstein is a critically acclaimed writer of highly intelligent business books. While he has written several high quality books, the one that has made the most impression was one of his earliest efforts, “When Genius Failed” which tells the story of Long-Term Capital Management, perhaps the most famous hedge fund to have failed ever.

Long-Term Capital Management was no ordinary hedge fund. It had among its employees a couple of Nobel laureates and used the most sophisticated computer technology. Its eventual failure became a business school case study of how markets defy formulaic explanation. Lowenstein is a very methodical and serious writer and tells the story of Long-Term Capital very well. In addition, he educates the reader on the complexities of the financial markets.

The story of Long-Term Capital begins with an ambitious Midwestern kid called John Meriwether, who has fascination for both gambling and stocks which takes him to the trading bonds at Salomon Brothers, where he eventually becomes the head of operations. Meriwether becomes the best bond trader of his generation, and was known never to make a wrong call – ever.

So, when he left Salomon Brothers to start his own hedge fund, a highly ambitious effort involving other ferociously smart people, just like him, there was no dearth of investors willing to put their money in. Meriwether sought to replicate the size and scope of the trading operation he ran at Salomon. He had his loyal team from Salomon with him, and also had the superstar academics, Robert Merton and Byron Scholes who had won the Nobel Prize in Economics. And he had over a billion dollars to work with.

Their philosophy was to make large trades controlled by a computer algorithm and make small amounts of money made on each trade. This was described as “vacuuming up nickels that others couldn’t see.” And the way to do that was to use leverage. And the smart guys at LLTC used plenty of it – which eventually led to their downfall.

In the first year of operation, LTCM returned 28% profits for their investors put in. They used stocks, currencies, and interest rate swaps and their trade carried high risks. But they made a lot of money, so much that in four years, LTCM quadrupled their capital and their investors were happy.

But this wasn’t to last as in 1998, their perfect world came crashing down. LLTC made too many wrong bets and the incredible amount of leverage they used to exacerbate the problem. Almost every firm on Wall Street had lent huge sums to LTCM. This created a perfect storm and put the US economy at severe risk.

The Federal Reserve got a coalition of fourteen banks together, which kept LTCM solvent by giving away $3.65 billion, which prevented the market from imploding. However, LLTC’s story was finished.

Roger Lowenstein’s story is a cautionary tale which warns against financial recklessness and using too much leverage. Sadly, as we all know, this warning wasn’t heeded in 2008, as the world plunged into a massive recession precisely for these reasons.